Participative financial instruments, capital raising instruments of great "appeal," but to be handled with care

Participatory financial instruments (1) (hereinafter, “PFI”) are perhaps the most appealing alternative finance raising tool; not surprisingly, because of their versatility, they are increasingly being used by Italian companies in need of capital injections.

A "typical" feature of PFIs is the possibility for the issuing company to freely outline the structure and characteristics that they must take on. Companies, in fact, have ample power to determine, according to their own needs, the pecuniary and/or administrative rights attached to the PFI, as well as the nature of the same, which, at times, brings them closer to debt securities, or, in other cases, to venture capital contributions.

This kaleidoscopic taxonomy that has developed in practice has entailed and continues to entail, however, some uncertainty regarding the identification of the tax regime applicable to various financial instruments. It is not surprising, therefore, that the Italian Tax Authority has repeatedly pronounced itself on this subject, gradually going on to outline a series of indices and parameters useful for the qualification, for tax purposes, of PFIs, so that the correct application of the tax due on the financial flows deriving from them can be consequently proceeded.

In this vein is the recent response to tax ruling no. 476 of Sept. 27, which provides an opportunity to return to an issue that, in our experience, is of particular interest to market participants.

In the present case, it was necessary to establish the correct tax treatment applicable - by the company - to the amounts paid to the subscribers of the PFI, as remuneration for the investment. In a nutshell, the subscription of the PFI entailed, in exchange for a capital contribution (not subject to repayment obligations), the right to share in the distribution of profits and/or reserves by the company, but with certain peculiarities:

• subscribers were privileged over any other parties;
• they were entitled to a sum equal to the initial contribution plus a "premium" calculated by applying an annual interest rate of 10 percent on the contribution paid (and not yet redistributed);
• once the subscribers had received sums equal to the initial contribution plus the premium, the PFIs would be automatically extinguished.

The issue brought to the attention of the Agency, with the aforementioned ruling, concerned the correct tax classification of the sums received as "premium," an issue that, in addition to being non-trivial, assumed important implications for the issuer, in fact:

• if the PFI returns were equated with dividends, the amounts distributed would be non-deductible for the company, according to Art. 109, para. 9 TUIR;

• conversely, if these returns had been assimilated to bond interest, the amounts paid would have been deductible from the company's gross income (albeit within the limits of Article 96 TUIR).

First, in order to understand this issue, it should be recalled that, in general, according to civil law, dividends are considered to be the sums distributed as a distribution of the profit earned by the company, among the individuals who have contributed risk capital to it (typically the shareholders). Conversely, interest (or assimilated) is paid to the subscribers of debt securities, according to rates of return/interest usually predetermined at the time of issue. The main difference between risk-capital, or debt, contributions turns out to be whether or not there is an obligation to return, at a given date, the invested capital, with the result that, in the presence of an obligation to return the sums, PFIs take on a similar nature to bonds.

The distinction is not without relevance for financial statement purposes: capital contributions go, in fact, to increase the company's assets (with the constitution of special reserves), while the issuance of debt instruments entails the recognition in the balance sheet of passive items, which, consequently, go to negatively affect the company's assets.

In this context, the company, in line with accounting standards, since the PFI did not provide for any obligation to return them, had considered them as equity instruments, resulting in the recognition of a special reserve.

However, the problem of the correct qualification, for tax purposes, of PFI arose from the irrelevance (as an exception to the principle of enhanced derivation (2)) of the classification adopted in the balance sheet and the necessary application of Article 44 TUIR, which provides criteria, to identify the nature of these instruments, partially not coinciding with what has been briefly outlined above.

Under this article, the classification of PFI as instruments assimilated to equity securities (liable to generate nondeductible dividends), and not to bonds (remunerated with deductible interest), follows:

1. first, from the circumstance that the relevant remuneration consists entirely of participation in the economic results of the issuing company. In other words, not only the an of the remuneration must derive from the existence of corporate profits, but also the quantum (thus proving incompatible with this definition the provision of returns at ex ante predetermined rates);
2. only secondly, and residually, by the existence of an obligation to return capital.

Based on these criteria, despite the classification of PFI on the balance sheet, therein considered as venture capital contributions, the Tax Authority, accepting the taxpayer's proposed argument, held that these instruments, for tax purposes, should be treated as similar to bonds.

From this it follows that the remuneration of the capital contribution (i.e., as mentioned above, the "premium" calculated with an annual interest rate of 10 percent, regardless of the operating results achieved) is deductible for the issuing company (in the same way as the remuneration of any loan).

In light of the above brief remarks, a number of considerations can be drawn.

It is clear that the correct classification of PFIs has implications not only for the issuing company, but also for the taxation of the subscribers, depending on their nature, bringing into play the different tax rules for dividends and interest, which are often not coincidental (see the application or non-application of participation exemption, etc.).

The issue becomes even more complicated where issuers and underwriters reside in different States with divergent tax rules (as PFI may be qualified differently in different Countries, falling squarely into the category of so-called hybrid instruments). Sometimes such instruments also pose not a few difficulties in the interpretation and application of bilateral conventions on double taxation, where the issue of determining the Country with taxing authority over such income arises.

These are therefore instruments of extreme interest, but to be treated with extreme care, weighing the pros and cons of their various possible structuring.

Avv. Paolo Visconti

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(1) For an examination of the regulatory framework and their scope of application, see our contribution on the subject: https://carmini-law.com/gli-strumenti-finanziari-partecipativi-inquadramento-normativo-e-ambito-di-applicazione.

(2) See Ministerial Decree of June 8, 2011.